At What Rate Should You Be Borrowing At?

Founders of Online Lending companies often don’t know what rate of return they should be borrowing at.

And one of the confusing parts is that these founders think lenders are pricing their loans based on the risk of the underlying assets.

Example: “if an Online Lender is financing high yield consumer loans — shouldn’t lenders give them capital at a high single-digit rate of return?”

The problem is… this might be true if the “asset risk” was the only risk that existed. But with brand new companies, there are 4 main types of risk.

(a) Asset Risk: how risky is the actual loan being made? And how much should a lender be charging for that risk? The earlier stage the company — the less data there is available, so the riskier the asset is deemed to be (the less data there is/less loan history there is, the less certain the outcome).

(b) Execution Risk: Can the originator actually originate these loans, underwrite the loans, collect the loans, service the loans, monitor the loans, and stay in business to keep doing so for a long time?

(c) Illiquidity Risk: What will happen to the market while the lender is in the deal?

(d) Growth Risk: will the company do something stupid as a way to keep growing quickly?

And so as companies pass through their three basic stages of life — their cost of capital will change over time.

Here is how I think about the risks at these different stages:

Stage 1 | The Early Days

In the early days of a startup’s life — the company has come up with a cool idea for a type of loan it wants to make. It then has to convince VC’s and hedge funds to give them the capital to operate and make the loans.

At this stage, ALL of the risks still exist. And the rate of return should look as follows:

Asset Risk + Execution Risk + Illiquidity Premium = Rate of Return.

Example: if this company was financing an asset similar to a high yield bond, the company should be borrowing at:

~8% + 2–4% for execution complexity + 2–3% for illiquidity = 12–15%.

However — one thing to remember is that while high yield credit trades at ~8%, there is TONS of data to validate this rate of return. For a new originator they may not have enough data to validate the asset risk — there may also be a “lack of data premium” that brings the rate up by ~2–3%. So the company might end up borrowing at 14–18%.

What are some examples of why “execution risk” is so important?

  • Origination risk: what happens if the lender does all of the work to execute a deal, invests their opportunity cost, and then the originator doesn’t make a single loan and everyone just sits on cash? Some premium should be charged for this risk.
  • Underwriting: what if the originator doesn’t do all the diligence on each loan as it promises it will? Startups are understaffed. And they often cut corners. There is a risk that a lender is backing a company that may not check all the boxes they were supposed to check.
  • Servicing Risk: Is the originator actually good at collecting payments from the borrower once the loan is made? No one knows for sure until this has happened.
  • Monitoring risk: Is the startup company making loans actually paying attention to their borrowers once they have made the loan? As an understaffed company… who knows. Much of being a good lender is monitoring loans once they’ve gone out.
  • Collections: When things go wrong — is the company going to be able to go through a claims process to get the money back? If they lend against a building — are they successful at actually going in, evicting whoever was in the building, and reselling it?
  • Solvency: can the company stay in business? If the originator goes out of business it’s up to the lender to go collect the loans themselves. Which is a pain in the ass. There is a premium that should be applied to this.
  • Small Loan Book: a small loan book is inherently riskier than a big one. Why? (1) because a smaller loan book often has more concentration and (2) because when things go wrong, they are expensive to fix on a relative basis. What happens if the loan book is only $10M and the originator goes bankrupt? It may cost $1M to pay for lawyers, a backup servicer, etc. That means 10% of the whole loan book goes out the door immediately, meaning the over-collateralization better be very high to get all the principal back.

Stage 2 | The Middle Days

In the middle days, companies will have made their initial loans, and will have proven that they can: originate, underwrite, service, monitor and collect. They will have more cash on their balance sheet, so will be less likely to go bankrupt. The loan book will be big enough where if something goes wrong it’ll be affordable to pay the lawyers and backup servicers to go collect. And there will be more data to prove the default rates were similar to what we thought they’d be.

But now new risks will come up. The company will have likely raised enough venture capital, at a high enough valuation, that they will feel the pressure to grow. And a company must face the following trade-offs:

Grow really fast and take risks that we don’t monitor well enough? Or grow more slowly and risk our valuation coming down?

On top of that — some lenders find that they have run out of “easy to reach” borrowers. Just like any other startup, finding customers 101–1000 is often harder than 1–100. And so it’s tempting to “style drift.” Meaning, make different types of loans than you were once making.

So the way we think about the rate of return at this stage is:

Asset risk + Growth risk + Illiquidity risk = total yield.

This might look something like: 8% + 2–4% + 2% = 12–14% rate of return (using the same example as given before).

Stage 3 | The Later Days

Eventually — a company will have passed a lot of its initial milestones. It will have finally proven it can reach scale, it will have lots of loan data, it will have a strong balance sheet and it will have de-risked its execution fears.

At this point — it may even be able to do a securitization, at which point it can eliminate much of its illiquidity risk as well.

Meaning the rate of return will be:

Asset Risk + small “newness premiums” = yield

But at this point, companies lose their flexibility to evolve their loan product (so they need to be certain that the type of loan they are making will stay consistent) and they can begin earning higher margins.

Closing Thoughts

It’s important to raise the right type of capital at the right time. If you try to raise “Later Days” capital too early, it’ll hinder your ability to iterate.

But if you style drift or don’t execute well, it’ll delay your path to cheaper capital.

All of these numbers are subject to structure, advance rate, and a million other factors. Please don’t take this as a “hard rule.” But it should at least be used as a framework.

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